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LOANS: Let's make a deal

"There is an abundant amount of capital in the marketplace for all property types, including retail," says Craig Butchenhart, an executive vice president at Legg Mason Real Estate Services in Philadelphia. "It's a very competitive sector. You have a lot of institutional bidding on these deals," Butchenhart says. Legg Mason Real Estate Services typically lends about $2.5 to $3 billion per year, about 20% of which is retail.

The lending environment has become more competitive because of the shrinking inventory of properties that need financing. "I think lending activity is down everywhere, not just for retail," says Mark Finerman, a managing director at Credit Suisse First Boston in New York. At Credit Suisse, the lending volume is down about 30% to 40% in first-quarter 2000 compared to the same period last year. Fewer shopping center owners and investors are shopping the market for capital due to rising treasury rates and increasing spreads that are making mortgage rates more expensive.

"We think there will be less demand for financing in 2000," says Thor Orndahl, a managing director at Prudential Mortgage Capital Co. in Atlanta. Orndahl believes the dip in lending activity is two-fold. Higher rates are one significant component. However, a drop in investment sales and refinancing deals also will impact lending this year. "There was a tremendous amount of early refinancing that occurred in 1997 and 1998, and the pace of transactions has slowed down from that of the past three years," he says.

"There is not as much out there," agrees Brett Ersoff, a senior vice president at New York-based Lehman Brothers. The slowdown started to become apparent during the second half of 1999, but that lull has not stopped lenders from pursuing shopping center deals. "Generally, we have been - and continue to be - bullish on retail for both small and large loans," Ersoff says.

Selective lending Lenders continue to have a healthy appetite for retail properties, but their palates have become more discerning. "There's no question that retail is not the No.1 product that lenders are looking for," says Sharon Kline, vice president in the Newport Beach, Calif., office of Houston-based L.J. Melody & Co. In 1999, retail accounted for $1.6 billion or 27% of the loans originated at L.J. Melody.

Retail ranks further down on lenders' priority lists for a variety of reasons. Some lenders already have heavy concentrations of retail in their portfolios, while others are wary of the volatility in the retail sector, Kline notes.

Nevertheless, lenders continue to target retail opportunities. "Right now, retail lending is as good as it's been in several years because the economy is good, same store sale are up across the board for retail and the centers that are being built are being built smarter," says Kline. Although there has been concern about overbuilding in some markets, new construction has not upset the balance between supply and demand. Retail occupancies remain healthy across the United States.

"There always has been caution with retail from our perspective, given the volatility in that sector," says Orndahl. "But we feel comfortable with the property type. We are very active on all fronts of retail lending with everything from unanchored strip centers to dominant regional malls.

Prudential Mortgage Capital funded several major retail deals in 1999 including a $159 million commercial mortgage loan to Westfield America Inc. Prudential Mortgage Capital originated the 10-year loan, and funded $79.5 million. New York Life funded the remaining $79.5 million. The mortgage loan is secured by Westfield Shoppingtown Montgomery Mall, a 1.25 million sq. ft. mall located in Bethesda, Md.

"I think some people are moving away from retail, and they're creating opportunities for those who remain," says Finerman. "Some people are shying away because they don't understand the differences among retail properties." Credit Suisse originated more than $1.5 billion in real estate lending in 1999, $500 million of which was retail.

The fundamentals Variables ranging from the economy to e-commerce have lenders scrutinizing deals and paying close attention to underwriting criteria. "We always have been very focused on the fundamental real estate value on the transactions that we loan against," says Orndahl. "We realize that credit can be volatile. We gain our comfort in the fundamental value of underlying real estate."

That being said, lenders recognize that some degree of retail failures are inevitable. "I've seen tenants that were investment grade go bankrupt within several years," says Finerman. "We focus on the real estate first, and then we focus on tenants." Credit Suisse is wary of power centers that are not well located, as well as malls that do not have strong sales. Those properties will be harder hit if they do lose a tenant due to bankruptcy, or sales will slide even further if the economy dips.

"We're not going to stretch to properties where locations are inferior," he adds.

Neighborhood centers anchored by food, grocery and drugstores continue to be the property of choice among lenders. Strong regional malls also are popular with lenders focusing on large loans in excess of $50 million. "Certainly, grocery-anchored is a mainstay in which most lenders have comfort," says George Bozzuti, vice president at GMAC Commercial Mortgage Corp. in New York. "Most other property types within the retail category we look at on an individual basis." GMAC focuses on criteria such as quality tenancy, good demographics, a strong physical asset and limited opportunities for new competition to enter the market.

While grocery centers continue to be the favorite, big boxes are out of favor with many lenders. "It's more difficult to locate financing for big boxes," says Andrea Settles, a loan originator at Atlanta-based Weinberg & Associates Inc. Deterrents for big-box lending include some slips in credit ratings, as well as bankruptcies and store closings. "Regardless of the retailer, lenders consider the credit rating," says Settles. "That is still very important."

Credit ratings are especially important in assessing power centers, where the demise of any one tenant, in a sense, affects the viability of a loan. "We recognize that during every economic cycle, different retailers are subjected to different risks at different times," says Bozzuti. "I would say that we're forever vigilant about trying to understand where the risks lie in regard to a tenant's credit in any given loan or retail property."

E-commerce's impact Lenders are becoming more selective on properties they choose to finance, in part because of the uncertainty surrounding direct retail marketing through the Internet. At this point it is still unknown what affect e-commerce will have on regional malls, large community centers and power centers. "I think at the moment, nobody knows the answer," says Bozzuti. "However, the retail industry itself is putting forth a lot of effort to stay in the race."

Traditional retailers are launching their own Internet sites to complement physical stores and compete for e-commerce business. "I think we and other lenders are beginning to take some comfort in the movement of traditional retailers into a combination of typical retail and e-commerce initiatives," says Bozzuti. A variety of retailers ranging from Barnes & Noble to Eddie Bauer now sell their products both in stores and on the Internet. "That seems to be tying things together well," he adds.

Finerman adds, "We understand that some retailers will be damaged by the Internet's growth, but we look for properties that should be able to weather a storm."

Credit Suisse First Boston focuses on properties that have attributes such as good traffic flow, a high volume of walk-by traffic and a strong entertainment anchor.

Others find that e-commerce has not made a significant impact on retail lending. "We're more cognizant of e-commerce, but I don't think any of us are seeing anything different," says Settles. "Our underwriting criteria has not changed much."

Out of favor Although lenders are eager to place capital in the retail sector, not all property types are generating the same interest. Power centers, outlet centers, Class-B regional malls and entertainment centers are among the properties that have fallen out of favor with lenders.

"We lend to securitize, so a lot of our focus depends on how we feel about certain sectors and also what CMBS investors are telling us," says Larry Kravetz, a senior vice president at New York-based Lehman Brothers. "Outlet centers are one sector that has fallen out of favor in the CMBS market. A fair amount of outlets have popped up alonginterstates in the past five to 10 years.

The long-term viability isn't there for a real destination area," says Kravetz. Retailers also are discovering other avenues such as the Internet and catalogs for unloading seconds and extra inventory. "So outlet centers as a means to do that are not as viable," he adds.

Lenders are finding big-box loans less desirable for a number of reasons. One factor has been credit rating issues with some tenants, as well as bankruptcies and store closings. "Many of these companies have grown so quickly and put up so many stores that they are over-leveraged and their credit has become suspect," says Butchenhart.

As a result, the underwriting on big-box centers is more stringent, and terms are not as good as in some other product types. For example, grocery-anchored centers and strong regional mall properties can typically obtain 75% to 80% loan-to-value ratios, while power centers rarely exceed 70% loan-to-value, Butchenhart says. In addition, spreads for grocery-anchored centers and malls are at 170 to 180 basis points, while big-box spreads are about 200. "We don't do that many big boxes, but when we do, the lease terms have to be long and strong," he says.

Many lenders struggle with the dilemma: What do you do with the big-box space if a 150,000 sq. ft. store is vacated? The other question lenders are forced to answer is, will tenants be available to snap up the space if the current retailer fails, says Kline.

Typically, big boxes are going to conduits for financing or opting for interim loans with the hope that the market will improve. Conduit lenders are more willing to finance power centers, and they give good loan-to-value and debt ratio coverage. Some conduits are offering 80% loan-to-value ratios. "It works for clients who want to maximize dollars," says Kline.

Specialty entertainment centers are another property type that is difficult to finance. "They are very popular on the development side right now, and very popular with consumers, especially in California," says Kline.

Fixation on floaters Floating-rate loans have become more popular as mortgage rates continue to climb. "In my opinion, rates are still cheap, although most real estate entrepreneurs think that rates are going down," says Finerman.

Traditionally, borrowers with short-term plans to reposition or sell a property have opted for floating-rate loans. Once a repositioned property achieves stable cash flows or occupancy, it is usually secured by traditional fixed-rate, long-term financing. Borrowers with short-term hold strategies favor floating-rate loans due to the flexibility and lower pre-payment penalties compared to fixed-rate loans.

But now an increasing number of borrowers are exploring the floating-rate option for stable properties. Some borrowers are hedging the market with floating-rate loans in anticipation that mortgage rates might drop. "The hope is that they will get a better rate in the short term, and be able to refinance for the long term later on," says Butchenhart. Although interest for floating-rate loans has spiked in recent months, the majority of borrowers still prefer fixed-rate loans. About 70% of the lending at Legg Mason is for long-term, fixed-rate loans.

As with the floating-rate loans, other loan programs have been introduced to assist properties in transition. Prudential Mortgage has seen considerable success with the Interim Program it launched in 1998. The Interim Program features a two-year, floating-rate bridge lending product that is later permanently financed under a 10-year term. Under the Interim Program, Prudential offers 90% loan-to-value financing on purchase and repositioning deals that can be permanently financed at 75% at two years.

"The aspect that differentiates our Interim Program from some others is that we don't sell those loans until they are permed out," says Orndahl. So during the interim period, the loan stays in Prudential's own portfolio. "We feel it gives us more flexibility until it comes time to [permanently finance]," he says.

Lenders will continue to assess e-commerce and overbuilding in certain markets, as well as continue to take a conservative stance on some property types. Ultimately, lenders are still targeting retail for a significant portion of their lending dollars. "Traditionally, retail has posed more risk than multifamily or well-located industrial, and it will continue to do so," says Bozzuti.

"But I don't see how any lender can withdraw entirely from the retail business," he adds. "You just need to be more selective."